How to Play an Arena Delay

The Food and Drug Administration is expected to render a decision on Arena Pharmaceuticals' (Nasdaq: ARNA) obesity drug lorcaserin by June 27. Except if it doesn't.

At the FDA advisory committee meeting held earlier this month, the panel of outside experts endorsed the drug, but some doctors suggested that the agency should require additional monitoring of the potential for lorcaserin to cause heart valve problems. If the FDA follows the advice, there could be a need for a Risk Evaluation and Mitigation Strategy, or REMS, or a post-marketing trial, both of which would require additional paperwork from Arena and could trigger a three-month extension.

That's what happened to VIVUS' (Nasdaq: VVUS) obesity drug Qnexa after the company modified its REMS, pushing back a decision. In fact, a delay is fairly common for drugs that get a six-month review cycle, which doesn't give the agency much wiggle room to complete its review. Decisions on Regeneron Pharmaceuticals' (Nasdaq: REGN) Eylea, Human Genome Sciences' (Nasdaq: HGSI) Benlysta, and Bristol-Myers Squibb's (NYSE: BMY) Yervoy were all delayed during their six-month review cycles.

Investors can bet on the potential for a delay using options to create a calendar spread. This morning you could buy a $7 call that expires on Oct. 19, after a potential three-month delay, for $1.79. The call allows you to buy shares at $7 per share no matter what the underlying share costs. To help pay for that call, we can sell the $7 call that expires in July, after the current PDUFA date, but before a decision if there's a three-month extension. Selling the call brings in $1.06 for a net cost of $0.73.

First, the bad newsThat $0.73 -- sold in contracts that control 100 shares, so $73 per contract -- is the most investors could lose because the two calls are at the same strike price and cancel each other out.

If an approval happens before July 20, shares would likely go zooming past $7. The value of the October call would go up, but so would the July one you're short. And because the binary even has already occurred, the difference between the price of the two calls will shrink.

If shares sink after a rejection, it'll cost less to buy back the short July call, but the value of the October call will plummet as well.

But there's big potential hereIf the two calls cancel each other out, how does an investor make any money? By eroding the value of the sold call while keeping the value of the October call high enough to make a profit. If there's a delay in the decision, that's exactly what should happen. The price of the July call is so high because investors are betting that the drug will go up after the decision. No decision, no premium pricing; the $7 calls that expire on June 15, for instance, sell for just $0.22 because investors expect that the decision won't happen by then.

Profit from the trade is made by selling the October call and either buying back the July call or letting it expire worthless. The potential profit from the trade has multiple variables, including whether the stock trades up or down on news of the delay and when the delay is announced, but if you use the values of today's calls as an indication, buying back the July call could cost around $0.22, the current cost of the June call. And with the October calls still able to take advantage of the binary event, they should retain most of their value. Figure a potential profit around $1.50 or basically double the initial cost, which isn't too shabby considering you don't even have to hold over the binary event.

A less risky alternativeIf you're confident in an approval but think there's a good chance of a delay, a covered call can be a good way to play Arena in the short term. Rather than buying the long-term call, investors can buy shares and, as in the calendar spread above, sell the July call.

A covered call is less risky because you'll still make money if the approval happens before the call expires. Buying the shares and selling the call would result in a cost basis of $5.12, and assuming shares went above $7 per share on an approval, you'd book a nice 37% profit.

If a rejection happens, you'll own shares that are sure to decline, but the loss might not be as much as it would be for a calendar spread.

If the decision is delayed, the call could expire worthless, assuming investors don't read too much into the delay and send the stock up substantially, otherwise you're left with that 37% profit. After the call expires, you could sell the shares or hold through the binary event. Either way, the credit from selling the call is yours to keep.

There's no doubling your money before the binary event in this scenario, but there's less potential to lose your entire investment.

Timing is everythingDoubling your money in about a month is appealing, but since the downside risk is close to losing it all, the calendar spread only makes sense if the chance of a delay is greater than 50%. I certainly won't be surprised if there's a delay, but I don't see enough of a margin of safety to make it worth the bet.

A covered call looks like a good alternative, but if you're confident in an approval, holding the shares outright will likely produce a better return on approval, and you don't have to guess whether there will be a delay or not.

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

You are forgetting one other scenerio if somebody dumps a bunch of naked short shares into the mix. You know like they did with Overstock.com. It's in the files that where accidently released to the public where certain ceo's admitted doing. You can read the whole story in Rolling Stone magazine or on the web. Never read anything about this in your articles. Why don't you grow some nuts and do a real article like that but then where would get a check from. Thats why nobody believes a word you people write!

The REMS for Qnexa originated with the FDA and was driven by a known concern about the teratogenic nature of topiramate, an active ingredient in the drug; the discussion of a REMS for lorcaserin (Arena) came from one or two committee members during the May 10th AdComm meeting It's not a statement that should be taken seriously. The concern did not originate with the agency. The REMS for Qnexa has been discussed since at least 2010.

Regarding valvulopathy, during the May 10th AdComm meeting the role of the 5-HT2C receptor in this problem was, essentially, dismissed by the agency. It would be very surprising if the agency extended the review cycle because of concerns about valvulopathy. I think if people want to fret about delays, why not worry about the CMC section--that's a real unknown.

Regarding the six month review time, it's not clear to what you are referring. If you’re talking about a priority review, delays don't differ substantially from standard reviews. In any event, the Arena NDA is a class 2 resubmission following a CRL. A class 2 resubmission just happens to have a six month review cycle; a class 1 is two months. In any event, I know of no meaningful difference in extensions of review cycles between a class 1 (two month cycle) and class 2 (six month cycle) resubmission. If you have information that demonstrates otherwise, I'd greatly appreciate reviewing the source.

Did you read the FDA Briefing Documents? I guess not, there is no potential for lorcaserin to cause heart valve problems. None. Show me the human study data that shows that not the statistical voodoo crapola. Just as many people on placebo had VHD incidents as in the drug arm.

The FDA's Dr. Golden stated that the 1.5 upper bound for the CI was arbitrarily selected and that the upper bound of 1.66 was not significant. Her words, not mine.

Then there is the ec250 data for the receptors that shows clearly that lorcaserin only affects the 2C receptor with any functional potency. It does not touch the 2a or 2b receptors.

Half of the panel members bases on their comments and questions clearly showed they did not read the briefing documents. Dr. Capuzzi is the prime example.

Again as Arena has stated several times, there is no CV signal, there is no VHD signal and there is no cancer signal. In addition, don't you find it interesting that the FDA has not discussed with Arena about any REMS required. Yes, it could happen now. But with Vivus those discussions happened prior to the AdCom.

Good explanation Dan. Fiction doesn't appreciate the light of truth. I think the science is too difficult for many people including some analysts to digest. Those who understand the science know unless there's corruption Lorcaserin will be approved. And if it doesn't due to corruption it will not go unnoticed. I doubt there will be a delay but even if a short one it'll be funny to see how clueless Frogstein types react vs. their reaction to Vivus'.

I don't touch options because chance of losing out is statistically much higher than gaining.

I am BioInvestorCA too--I had problems logging in, so signed up again.

My guess--and it's only a guess--is that the author confused a class 2 resubmission with a priority review. I think unless you live and breathe this sort of thing, it can get confusing. Mistakes are part of learning.

If anything an argument could be made that six months for a resubmission (stress the first syllable) is too much time. The bulk of the review was completed before the 2010 CRL. If a REMS is in the offing, the issue would most probably have been raised in 2010; at least, we'd have a reasonable indication that it is a possibility.

The safety issues raised in the 2010 CRL have been addressed; the drug has demonstrated efficacy. There's never a guarantee of marketing approval until the FDA gives its decision, but things are looking good for Arena.